The Federal Reserve Cuts Rate for the First Time Since 2020
Core bonds were up 5.2% in the third quarter as the market began to price in significant cuts to the Fed Funds rate. This brings the one-year return to 11.6%, the highest rolling one-year return in more than 20 years. Despite recent gains, core fixed income remains in its longest drawdown since series inception in the mid-1970s. It has been 15 quarters since the index made a new high, which is three times more than the previous longest stretch of five quarters between 1980 and 1981.
Corporate bonds outperformed Treasuries in the quarter by 58 basis points. This brings the year-to-date excess return versus Treasuries to 1.8%. Mortgage-backed securities (MBS) outperformed Treasuries by 94 basis points in the quarter. They have now outperformed corporate bonds by 137 basis points over the last five months.
The 10-year Treasury issue finished the quarter at 3.78%, which is a 62-basis point decline and near the one-year low. Over the last 12 months, the one-year Treasury yield has fallen 145 basis points to 4% while the 30-year Treasury yield has only fallen 58 basis points to 4.12%. Many Treasury curves have reverted to a normal slope as the market prices the prospect of a total of nine cuts to the Federal Funds rate.
The Fed cut the Fed Funds rate for the first time since 2020. The question was whether it would be 25 basis points or 50 basis points. The market implied odds indicated the highest uncertainty of a Fed outcome since the data began being published in 2015. The Fed opted to cut 50 basis points. In the 10 days since, the S&P 500 Index is trading higher and longer dated Treasury yields are up about 15 basis points. Corporate bonds have also outperformed.
Portfolio Positioning
Last quarter we noted that we did not view the policy rate of 5.5% as restrictive in the context of 5.7% nominal GDP, a federal deficit of 5%, and the S&P 500 Index at an all-time high. Since then, the deficit is back up over 7%, equity prices are higher, and now the Fed has lowered interest rates. Financial conditions are not tight and will only get looser if equities continue to rise.
We lowered portfolio duration to underweight just ahead of the Fed meeting as the Citi Surprise Index looked like it was turning higher just as the Fed was poised to oversize a rate cut. Bond yields should track directionally with economic surprises, yet in this case the bond market appeared to be solely focused on Fed rhetoric. We think Fed rhetoric will follow the Citi Surprise Index. As the economic data improves, the Fed will take a much less dovish communication stance, which will feed into higher bond yields. Since the Fed meeting the Economic Surprise Index has continued higher, now above zero for the first time since May and posting its largest 60-day improvement in over a year.
The Fed will likely follow through with interest rate cuts in November and possibly December. It would be unprecedented to push more than 75-100 cuts into a rising equity market and easing financial conditions. If the S&P 500 Index moves higher and averts the 10% correction territory, we think yields will move higher as the economic data comes in better than expected. This would allow corporate bonds to outperform, but also allow MBS to likely do just as well given starting spreads among the two asset classes.
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